Operating leverage is a measure of how revenue growth translates into profit. Revenue is directly translated into profit because of high fixed cost. Generally asset heavy companies have an effect of operating leverage. Asset heavy industries are the industries which have lesser asset turnover (Ratio).
How revenue is directly translated into profit by fixed cost let us understand:
First of all this doesn’t means that company doesn’t have variable cost or if the revenue is increasing the variable cost is not increasing. This statement means that the company has major cost as fixed cost (fixed cost are constant no matter how much sales/revenue company is generating). In such cases, any increase or decrease in the revenues will (partially but directly) flow to the bottom line (in the form of profit or loss). Now let us understand the following with the help of numbers.
What happened in the above example?
A 50% hike in a revenue brought 177% increase in PAT. This is because “The revenue(% wise) is increasing faster than cost (% wise). Overall cost is increasing but at lower pace than the revenue”. This was the good scenario where we expected that company sales will grow by 50% but what if company’s revenue declines? Now let us see an example for the same.
Due to which factor/ Component this thing is happening let us understand it.
This is happening because company is not able to reduce it’s cost. Revenue is decreasing but cost isn’t that’s why people quote that Operating leverage is double edge sword. .
Things to remember:
- As an investor point of view you need to have an good grip on industry because if you that company (operating leverage one at peak) then you will lose your money.
- Companies having huge fixed costs (generally, asset heavy companies) enjoys the benefits of operating leverage. However, one needs to also focus on the downside of the operating leverage.
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